Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Thursday, September 22, 2011

State Securitiies Officials Concerned with Legislation Lifting General Solicitation Ban in Rule 506 of Regulation D

State securities commissioners have urged Congress to carefully consider the impact of legislation that would lift the general solicitation ban in Rule 506 of Regulation D. In testimony before the House Capital Markets subcommittee, Arkansas Securities Commissioner Heath Abshure, speaking for the North American Securities Administrators Association said that there are significant concerns with the The Access to Capital for Job Creators Act (H.R. 2940), which would will allow general solicitation in Rule 506 offerings. Rule 506 is a safe harbor under Section 4(2) of the Securities Act, noted NASAA, and these securities are meant to be private offerings. With this expansion, emphasized Mr. Abshure, we are getting further and further away from the ideas of a private offering under Section 4(2).

NASAA noted that when there is no limit on the number of offerees, the size of the offerings, or the manner of offering, it is a public offering. The fact that sales may only be to accredited investors does not change the public nature of the offering. Further, NASAA believes that it is going to be impossible to limit the sale to only accredited investors when they advertise to everyone. Indeed, there will be no reason to believe that any investor, seduced by the public advertising, will hesitate to be dishonest when completing the investor suitability questionnaire.

Companies using the Rule 506 exemption can raise an unlimited amount of money without registering the offering with the SEC as long as they meet certain standards. Although the SEC has performed limited reviews of private offerings since 1982, they had been subject to regulatory review by state securities regulators who routinely screened bad actors from raising money through private securities offerings. This regulatory authority was stripped from the states in 1996 when Congress passed the National Securities Markets Improvement Act (NSMIA). As a result, said the NASAA official, today private offerings receive virtually no regulatory scrutiny.

Since NSMIA became law, the use of the securities exemption found in Rule 506 has increased significantly. Although properly used by many legitimate issuers, noted NASAA, the exemption has become an attractive option for individuals who would otherwise be prohibited from engaging in the securities business. Indeed, the state official said that the exemption is being misused to steal millions of dollars from investors through false and misleading representations in offerings that provide the appearance of legitimacy without any meaningful scrutiny of regulators. Private placement offerings have been identified by NASAA as a top trap facing investors in three out of the past five years.

NASAA believes that there is a more reasonable way to balance the reasonable needs of businesses with reasonable protection of investors. One option is for Congress to consider is the Model Accredited Investor Exemption (“MAIE”), which was adopted by NASAA in 1997. This exemption, subsequently adopted by 32 states, maintains appropriate investor protections while giving small businesses the ability to conduct general solicitation and a cost-effective means to raise capital.

The MAIE allows the issuer to use a general advertisement to “test the waters.” There is no limit on the number of investors under the MAIE, and there is no limit on the amount an issuer may raise in an offering under the MAIE. Although only accredited investors may purchase securities offered through the MAIE, dissemination of the general announcement of the proposed offering to non-accredited investors will not disqualify the issuer from claiming the exemption.

The MAIE also contains a number of important provisions that reflect the speculative nature of the offerings and the need for reasonable investor protections, such as limiting sales to accredited investors. Moreover, the MAIE is not available to issuers in the development stage that either have no specific business plan or purpose, or have indicated its business plan is to engage in a merger with an unidentified company. Small businesses, typically with no operational history, untested technologies, and limited resources, are extremely speculative. It is absolutely vital that any efforts to lessen the requirements of the capital-raising process for these companies maintain appropriate, necessary investor protections. The MAIE, or a provision containing similar protections, is a reasonable middle ground that was adopted by NASAA.

Rather than passing H.R. 2940 in its current state and further limiting states’ ability to protect investors, NASAA urged Congress to instruct the SEC to adopt an exemption to coordinate with this model exemption.